US economy contracts but it's not all bad news

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Don’t be alarmed at the news that the US economy contracted by a surprise 0.1%, according to the first estimate of fourth quarter gross domestic product. The American economy isn’t heading for another nasty recession, following the UK and other EU economies into the mire.

Other underlying data shows the US economy remains solid. Look at the US Federal Reserve’s stance, which supported that analysis after its first policy making meeting for 2013 overnight. Both consumer spending and business investment remained solid in the quarter, as did housing, which will emerge as the major driver of growth later in the year. However, falling inflation may become a concern.

If you strip out the negative contributions from inventories and government spending, the growth rate is closer to the 3.1% annual rate in the third quarter. The data will be firmed up by revisions in February and March in the areas of consumer spending, personal income, exports (which were negative) and inflation .

The news however surprised markets which had been looking for growth to slow to around 1-1.2% from the 3.1% annual rate in the September quarter. Of course, the rise in payroll taxes and looming spending cuts will impact growth this year, but the private sector is much stronger than many US economists had thought.

For Australia, there’s nothing that will frighten markets, in fact the report will encourage the rebound in share markets that is now underway. Only an act of political stupidity in Washington, such as the US congress pushing America into default over the debt issue issue, could derail the rebound and the economy.

Private demand was strong with final sales in the US private sector up an annual 3.3% in the December three months, the best growth for nearly a year. Growth over the year was 2.2%, up from 1.8% in 2011.

The Fed confirmed this view in its post-meeting statement. As a result there was no change in the Fed’s current round of easing, with it reaffirming the commitment to spending $US85 billion a month on mortgage and government securities, while it maintained its low interest regime for as long as unemployment remains above 6.5% and inflation remains at or below 2.5% (annual).

The GDP report shows that most of the contraction was generated by a sharp fall in business inventories and current defence spending in the quarter, both of which had risen sharply in the three months to September. Both contributed negative growth of 1.3 percentage points in the December three months. Economists point out that there will be a rebound in inventories in the first two quarters of this year.

Consumption grew by 2.2% (annual), adding 1.5 percentage points to growth, while business investment jumped by an annual 8.5%. Housing’s rebound was underlined by annualised growth of more than 15% in the quarter and a 0.4% contribution to growth, which can only increase as the year goes on.

Consumer spending rose 2.2% (annual) in the quarter. Amid the surge in business investment was a 12.5% jump in spending on equipment and software. US economists point out that both areas of spending are signs consumers and business are more confident that the economy is well placed to ride out the impact of spending cuts and tax rises and whatever else American politicians throw at it.

But unemployment remains stubbornly high, there are still dangers lurking in the eurozone (think Italy), and the Middle East continues to be a worry. The most intriguing part of the report though was the absence of any inflationary pressures. Headline prices rose 1.3% (annual) in the quarter, down from the 1.4% rate in the third quarter. Excluding food and energy, prices rose 1.1% (down from 1.2% in the September quarter).

Another couple of quarters with price growth around this rate will make the Fed very concerned that deflation may be on the way, especially if the higher taxes and spending cuts have a bigger than expected impact. Inflation is a very long way from the target level of half a per cent above the 2% long term level that the Fed adopted late last year as one of its main indicators (unemployment above 6.5% was another) for maintaining interest rates at the current record low.

Those economists and investors worried about inflation are barking at ghosts at the moment.